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| Still selling bonds |
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| 谢国忠 发表于 2008-7-8 23:15:00 |
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In early June, global financial markets gyrated down on central banks' tough language on inflation. The BoE said it would even accept a drop in living standard for containing inflation. The Fed said that the risk of a serious economic downturn was small and it would shift its priority to inflation fighting. At one point, ECB sounded like a raging bull for hiking interest rate. Even the Bank of Japan mentioned the risk of inflation. At one point, market priced in four rate hikes by the Fed by mid-2009. As a result, dollar firmed, oil price stabilized, and yield curve flattened around the world. If the inflation fighting is real, it bodes well for bonds. But, I think otherwise.
While rates will rise, maybe earlier than mid-2009 that I expected before, they won't be aggressive. If the Fed and ECB raise rates in the summer, it is intended to give substance to their talk but won't herald rapid rate increase ahead. Market is probably jumping ahead of itself. The bottom line is that rising rates would trigger a deep recession and central banks, while desiring lower inflation, are not yet ready to accept a deep downturn in exchange. The tough talk is mainly aimed at pushing down oil price, which would ease inflationary pressure and decrease the need for raising interest rates.
Indeed, the central banks are already backing off in a confused fashion. The ECB now says that it may raise interest rate once. The Fed continued its language on the balance of risk between growth and inflation. It said that the growth was at less risk and inflation at more risk, i.e., it could be in a position to raise rates. It is still not saying that it would raise rates to contain inflation even if growth is at risk. The language confusion just indicates the central banks wish that inflation would go away without rate hikes that would bring down growth also. They are in denial. It is a stagflationary world. Inflation fighting is meaningful only if central banks accept and trigger a deep downturn.
This jawboning strategy that promises a painless way to ease inflation is failing. Market sees through the talk and understands that central banks still put growth ahead of inflation. They won't hike rates as fast as inflation rates are picking up, i.e., monetary policies around the world would remain loose and boost inflation. Inflation in the global economy would head up, not down. On the other hand, the bursting of the credit-cum-property bubble is weighing down economic growth. Surging oil price allocates too much money to a few who can't spend it all and, hence, is bad for growth too. The IMF now expects global growth to slow by one percentage point in 2008 to 3.7% and inflation rate up by over one percentage point to 5.5%. Inflation rate is significantly above growth rate. The gap would widen in 2009. It seems that the world consensus as well as the reality is moving towards stagflation.
Let me do some chest pounding here. In late 2006, I predicted stagflation for the US and the global economy in 2008. At the time, not a single soul I met agreed with me. I believed that the mild recession after the tech burst in 2000 was due to the rise of a global property bubble and wrote repeatedly on the subject then. But, I struggled with the likely ending. I played with the deflationary ending for a while. The bubble could burst on its own when speculators suffer acrophobia. The collapsing asset prices would depress demand, exposing overcapacity and triggering deflation.
As the global asset bubble went on and on, I questioned this scenario and realized that the deflation ending wouldn't happen. The reason is the unlimited risk appetite in the global financial system. Most speculators play with other people's money ('OPM'). They are paid a cut on the speculative gains but don't share the speculative losses. This incentive system permeates the global financial system, especially with the rise of hedge funds, private equity firms, and the proprietary trading at investment banks. Hence, as long as central banks keep monetary policies loose, the resulting monetary growth would flow into some asset classes. As the credit-cum-property bubble bursts, the money was likely to go into commodities. A commodity bubble is far more inflationary and less growth friendly than a property bubble. A property bubble boosts growth through wealth effect. Hence, its inflationary impact is via its growth impact. A commodity bubble boosts production cost, which depresses growth, and boosts inflation at the same time.
The commodity bubble will end only when central banks decrease money supply. That will take a long time. Central banks have been playing Santa Claus for twenty years as inflation declined on globalization and the collapsing energy demand in Russia and Eastern Europe, which gave them a license to print money without immediate inflationary consequences. This is why central bankers like Greenspan were so popular. In an inflation-prone environment, effective central bankers should be tough taskmasters like the Fed Chairman Paul Volker (1979-97) or the President of the Deutsche Bundesbank Hans Tietmeyer (1993-99). Human nature doesn't change overnight. The current generation of central bankers couldn't transform into Volkers or Tietmeyers. They enjoy the limelight too much and love to be loved. My stagflation call was based on two factors-the love seeking central bankers and the OPM wielding speculators.
A prediction is meaningful only when one sees irrational factors that block efficient markets. Inefficient factors ultimately come from the irrational side of human nature or some institutional flaws. I am not always right. On oil, for example, I underestimated the interplay between supply tightness, demand strength due to subsidies in emerging economies, and the power of speculative capital. The bubble has lasted much longer than I expected. When the Fed cut interest rate last summer, I understood its significance for oil and other commodities and called for a massive bull run for oil due to the Fed's turnabout on its policy.
Based on my understanding of today's central bankers, I believe that the inflation crackdown is more noise than substance. They still believe that, through clever posturing, they can scare away oil speculators and, hence, support their loose monetary policies to simulate growth. Their clever posturing, however, is running into the brick wall of OMP wielding speculators who have no downside, only upside in calling the central bankers bluff and pushing oil price ever higher.
The game between central bankers and speculators would end when inflation is high enough that public opinions put inflation fighting ahead of growth stimulating. Today's central bankers are like politicians and swayed by public opinions. As the pain from asset deflation still dominates public opinions in the US and other developed economies, today's central bankers don't have the guts to go against popular opinions and do the right thing for the future. They are like their counterparts in the 1970s and won't act preventively. The world, unfortunately, is likely to repeat the stagflationary cycle of the 1970s.
Stagflation should be the most important consideration for investors in 2008 and 09. Of course, one should carefully consider where the prices are and how much they have priced in stagflation. The biggest mis-pricing I see is in the bond market. Despite a gut-wrenching bear market this year, bond prices are still grossly overvalued. This is the biggest risk to central banks with large foreign exchange reserves (e.g., China, Japan, Russia, and Saudi Arabia). What can they do to dodge the bullet of a collapsing bond market?
The yield on the 10Y US treasury has risen 30bps points to 4.12% in a month. This is a massive bear market in the bond land. The current level, however, is still far from sufficient in reflecting future inflation. The US's inflation is likely to be between 5-5.5% in 2008 from 4.1% in 2007, considering that the inflation in the past twelve months was 7.2%. The 10Y TIPS or inflation protected bonds yields 1.63%. The difference, 2.49%, is the market inflation expectation for the next ten years. The bonds are vulnerable to both changing inflation expectation and rising real interest rate.
Some surveys show that American consumers expect inflation to average above 3.5% over the next five years. This is actually not too far off from the post World War II average. Is the financial market or consumer right? Normally, financial investors should be more reliable than consumers. The former are armed with research capacity and investment experience. However, the investor base for the US treasuries is a special one. Central banks around the world are the main buyers of treasuries. They are reluctant buyers. Their funds come from trade surpluses and capital inflow. Both are driven by the US monetary policy. When the Fed has an expansionary monetary policy, central banks around the world are flooded with dollar inflow and, to prevent currency appreciation, are forced into accumulating foreign exchange reserves. For liquidity and security they usually buy the US treasuries. This angle suggests that the treasury pricing may not be rational and may not reflect fundamentals.
The long-term average real interest rate for US treasuries is about 2.5%. The current level of 1.6% is probably too low. Maybe the flight to quality is a factor. As other asset classes tumble, the safest asset class-TIPS becomes overvalued. But, as the financial crisis works its way through, probably, by the end of 2009, the TIPS's pricing could also normalize.
The inflation priced into the treasuries is also too low, even thought the expectation has risen from 2.2% in January to 2.5% now. The Fed is prone to stimulating. It has the triple mandates of keeping inflation down, supporting employment, and maintaining financial stability. The compromise that it must make means that it will overshoot its inflation target of 2% by a significant margin. The historical average of 3.5% is a good indication for the future. The US economy is likely to suffer a decade of low growth due to (1) the retirement of the baby boomers, (2) the skyrocketing healthcare cost, and (3) rising competition for natural resources. The Fed would be under enormous pressure to stimulate the economy. The chances are that the US inflation over the next decade would be above the historical average and the dollar would remain in the bear market for the foreseeable future.
The involuntary investor base for government bonds is the main cause for the pricing distortion. When the market comes to its senses, the yield on the 10Y US treasuries may need to rise by 2-2.5 percentage points. The re-pricing of the US treasuries would have similar though smaller impact on government bonds in other countries like Japan, Euro-zone, or the UK. The central banks around the world are holding a dangerous asset. As they are the market, they cannot all escape without causing the price to crush. They are collectively trapped. Hence, the first mover would gain.
The oil exporters like Saudi Arabia are flooded with money. The OPEC countries make $4 billion everyday from oil exports. They can afford to hold the US treasuries despite the downside risk. The loss may not be so big for them. China can't afford to behave like them. China's foreign exchange reserves come mostly from labor-intensive export industries like electronics, garments, shoes, furniture, etc. Every dollar is earned from the sweat of the workers who make $100 or so per month. China's large foreign exchange reserves reflect the number of workers in China, not good fortune or high value added. Hence, China can't afford to waste a penny of its $1.7 trillion foreign exchange reserves. China's central bank should decrease the duration of its portfolio as much as possible to avoid capital losses from potential treasury re-pricing.
When central banks get out of treasuries, what could they buy? As their funds are vast, the only alternative is stock market. Global stock markets have been declining and will probably decline more. They are trading at 2.3 times book value at present, neither expensive nor cheap. By the way, the only reliable measure for market value in the long run is the price to book value ratio. As the world economy is still on the way down and interest rates on the way up, stock markets are in rough territory. But, the current level is supportable over time. If central banks buy over the next twelve months, they may suffer some losses in the short term but should make money in the longer term. Further, given their sizes, they cannot buy when markets are buoyant; their buying would push up markets so much that they end up overpaying and losing money in the long run.
Stocks may not perform well during stagflation. As rising interest rates and slowing economies depress earnings and increase the holding cost. But, the value of stocks will not get inflated away like bonds. Companies have assets and debts. The assets are value preserving, while debts are likely to decline in real value with inflation. The diminished profit outlook during stagflation depresses market valuation. But, as soon as the stagflation is overcome, stocks will perform well to recover the lost ground during deflation. To a large extent, the bull market in the 1980s was due to its undervaluation during the stagflationary 1970s.
If central banks do decide to switch into stocks from bonds, the best approach is probably to buy indexes via index funds or proxies. Over the long term, index funds outperform over 90% of the actively managed funds. This is because the later incur too much transaction costs without adding enough value in stock picking. Central banks are government institutions and would struggle to build up stock picking capability. However, central banks probably know macro trends better than an average investment house. It is possible to extend this skill to pick sector indices.
Holding bonds is probably the worst investment position today. Private investors have fled bonds already. Central banks are supporting bond markets. It's time for them to leave. China should run for the exit first.
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